Sterne Agee: Three Gold Stocks We Like

December 5, 2012

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Sterne, Agee & Leach

Precious-metal equities appear attractive right now. The combination of positive macro, micro and technical drivers should allow gold prices to rebound and achieve new highs during the next 12-18 months.

Central banks across the world continue to expand gold reserves. Central bank buying hit almost 100 tons in the third quarter, down sequentially from the record second quarter, but still very strong for an annualized run-rate of 400 tons.

Central banks continued to accumulate gold in October as well, with nearly 40 tons purchased in the month. Brazil's central bank increased its gold bullion reserve by 17.2 tons in October, while Kazakhstan added 7.5 tons to its gold reserves.

We expect silver demand for industrial applications to drop for the second consecutive year in 2012. Slower global economic growth and thrift in certain applications, most notably photovoltaics, have led to less than stellar demand for industrial applications over the past 18-24 months.

We expect modest pick-up in industrial demand in 2013. We expect silver supply from mine production to increase 4% to 5% in 2012, mainly on account of increased supply from China, Mexico and Russia.

Market has been reliant on investors to absorb the vast bulk of the surplus since 2008--we would expect that to continue in the foreseeable future. We expect investment demand for silver to hit record highs in 2012, and continue increasing in 2013.

While witnessing record low Treasury and German bond yields that have been signaling deflationary trends, global investor views on currencies and their supplies and continued negative real interest rates combined with potential excess liquidity, should help precious metals.

Also, euro-zone debt absorption, U.S. fiscal cliff possibilities and Chinese government attempts to simulate demand should help relative performance as well. During the next 18 months, we expect gold to average $1,750-$1,800 per ounce with upside to $2,000 and downside to $1,400.

On silver, we peg a mid-$30s average with potential to reach new highs as potential emerging-market economies stabilize and investor accumulation accelerates.

At current levels, we believe well-capitalized producers appear underpriced relative to our pricing and volume expectations. Gold company managements and their boards have emphasized to investors an increased attention on appropriate returns on and of investor capital.

With a renewed focus on returns at the expense of production growth, gold companies operating margins could outpace expected increase in gold prices.

Continued focus on cost management and rates of return could lead to an increase in gold companies operating margins, which could set the stage for re-rating of gold equities valuation multiples.

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